Making Banks Safer: Can Volcker and Vickers Do It?

Summary: This paper assesses proposals to redefine the scope of activities of systemically important financial institutions. Alongside reform of prudential regulation and oversight, these have been offered as solutions to the too-important-to-fail problem. It is argued that while the more radical of these proposals such as narrow utility banking do not adequately address key policy objectives, two concrete policy measures – the Volcker Rule in the United States and retail ring-fencing in the United Kingdom – are more promising while still entailing significant implementation challenges. A risk factor common to all the measures is the potential for activities identified as too risky for retail banks to migrate to the unregulated parts of the financial system. Since this could lead to accumulation of systemic risk if left unchecked, it appears unlikely that any structural engineering will lessen the policing burden on prudential authorities and on the banks.

[An excerpt from the Working Paper reads]:

The business of banking involves leveraged intermediation managed by people subject to limited liability and, typically, to profit sharing contracts. This combination is well-known to generate incentives for risk-taking that may be excessive from the perspective of bank creditors. Creditor guarantees such as deposit insurance are known to exacerbate this incentive problem because they weaken creditors’ incentive to monitor and discipline management.

These issues are magnified in the case of systemically important financial institutions (SIFIs). Owing to their size, interconnectedness, or complexity, the negative externalities emanating from financial distress at SIFIs makes them a source of systemic risk, leading to them being perceived to be too-important-to-fail (TITF). Consequently, the market implicitly—and often correctly—assumes that apart from explicit deposit insurance, creditor guarantees of a much wider nature would be extended when such firms are threatened by imminent failure.

This serves to weaken the mitigating force of market discipline. Prior to the crisis, the high likelihood of public support assumed in a distress situation contributed to the ability of SIFIs to carry thinner capital buffers at lower cost, acquire complex business models, and accumulate systemic risk. This trend was reinforced by the diversification premier attributed to universal banks by market participants and prudential authorities, enabling them to integrate the provision of retail, investment, and wholesale banking services without erecting the necessary firewalls there-between. These developments resulted in networks of financial interconnections within and across internationally active SIFIs that proved to be difficult, time consuming and costly to unravel. This made it seemingly less costly, during the crisis, to allocate tax payer resources to preventing SIFI failures than to allowing them, with subsequent resolution and restructuring of their businesses.

Diversification of business lines could serve to better protect a universal bank against idiosyncratic shocks that adversely impact individual lines of business. . . .